The US may never recover from the current financial crisis. The Fed is pouring money into the system and holding prime interest rates down, yet mortgage interest rate predictions are still rising – how can this be? And what does it mean for homeowners?
The relationship homeowners need to grasp to understand interest rate predictions is the interplay between interest rates set by the Fed and mortgage interest rates charged by mortgage lenders.
Interest rates set by the Fed affect the cost of funds to mortgage lenders. Financial institutions don’t own all the money they lend out as mortgages – they actually borrow 90% of what they lend out to homeowners on the wholesale market.
When the Federal Government lowers prime interest rates, it, therefore, lowers borrowing costs for mortgage lenders – you would think that in that case, mortgage interest rate predictions would fall. However, banks and other lenders may choose not to pass on the reductions to homeowners.
The reason is not profiteering – there is enough competition in the mortgage lending market to ensure that no one lender can profit unfairly. The reason is that lending against homes is now a whole lot more risky, and increased risk raises interest rates.
Mortgage lenders are charging everyone more interest to offset their losses on the few who will fail to pay their mortgages.Until the US housing market settles down, default risk will stay high, and interest rate predictions will keep going up.
Of course, the government can’t lower interest rates continuously. The apparent interest rate (called the “nominal” rate) includes the rate of inflation. To find the “real” interest rate, you need to subtract the inflation rate from the nominal interest rate.
Today, when you do that, you get a negative number! In other words, nominal interest rates are not keeping pace with inflation.
We all realise that this is a situation that surely cannot continue for any length of time. Soon the government will have to raise interest rates to at least break-even levels, matching the rate of inflation. This interest rate rise will definitely flow through in to mortgage interest rates.
What we are saying is that it’s really only a matter of time, and not much time, before mortgage rates rise again.